Inheriting an IRA can be overwhelming, especially with the recent changes in tax laws. In this episode, Bridget and John break down the four essential things you need to know about inheriting an IRA. From understanding the new 10-year rule to tax-saving strategies, we cover it all. Make sure to watch until the end for valuable insights and tips!
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TRANSCRIPT:
Bridget: Rules around inheriting an IRA have recently changed, and now there's even more clarification about what you are required to do. We think there're four things that you should know. I’m Bridget Sullivan Mermel. I've got a fee-only financial planning practice in Chicago, Illinois.
John: And I'm John Scherer. I've got a fee-only financial planning practice in Middleton, Wisconsin. Before we dig into the four things you need to know about inheriting an IRA, we want to remind everybody to hit that subscribe button. That helps other people find this information on YouTube. And with that, let's jump in and talk about inherited IRA issues, Bridget.
Bridget: Okay, John. Let's get it going. Start with number one.
John: Yeah, as you said in the introduction, the rules have really changed. The other day I was looking this up, and there have been three major tax law changes in the last decade that in various fashions have affected this stuff. And so, you think, oh, yeah, that's right. I inherited an IRA from my dad 10 years ago or 15 years ago or whatever it is. Now the rules have changed, and maybe they've changed how it affects what you're looking at here or what you have to do as you inherit. One of the big changes that we talk about a lot with our clients is that it used to be that when I inherited an IRA—my mom passed away, and I was the beneficiary—I then had to take a little bit of money out each year.
It's called a required minimum distribution (RMD). I have to take some money out using this RMD, but I could stretch it out over the course of my lifetime. I was 40 when I inherited. I have to take a little chunk out each year for the next 30, 40, 50 years, right? That rule changed. And now the rule is when I inherit that IRA from my mom, I've got 10 years, and I have to take everything in that IRA out in 10 years. And why is that important? For regular IRAs, when that money comes out, it's taxable as regular income. So I've got 10 years to add all this regular income on top of my other income from my job and that sort of thing.
So that's a really big change when somebody inherits money. Of course, if you inherit $10,000 or $20,000, it's a great sort of gift type of thing. But from a tax standpoint that doesn't change the numbers a whole lot. The problem comes when somebody inherits a million-dollar IRA, a life-changing number, but then suddenly it’s also a tax changing number that we've got to be aware of. And not everybody is aware that when they inherit this, they've got to start taking that money out, and they have a 10-year time frame to do that.
Bridget: Yeah. And one thing I would just want to make sure is clear is there's a grandparenting type of provision. So if you inherited an IRA from somebody who died before this law came in, you're still okay, you got the rest of your life to take the thing out. But if it's more recent, then you've got to follow this ten-year rule.
John: That's right. And so, if you are already in a position where you're taking out those distributions, I believe that the drop date was at the beginning of 2020, but you can look up all the specifics. If you're already doing it, you can probably keep what you're already doing. But if you inherited this in the last three, four, five years, go back and take a look. We've got some folks who have been taking out those minimum distributions, and then they come to us as clients and we find out, hey, wait a minute, you've got six years to drain the rest of that account. We got to do some planning on that to try to figure out when's the best way to take that and what's the most tax smart way to do that stuff. So just be aware.
If somebody dies today, clearly, it's in that 10-year rule. If it was in the last five or so years, go back and take a look. There's some homework from this episode. And while we’re talking about taking money out of an inherited IRA, one of the things to be aware of is that you're allowed to take it all out at once if you want to. If you got $1 million, you could take it all out. As you might imagine, though, the downside to that is the cost of taxes. Remember we're talking about regular IRAs, so all this money coming out is taxed at regular income tax rates. So while you can take it out all at once, you probably don't want to from a tax standpoint.
Bridget: Yeah. For instance, someone I was talking to inherited about $250,000 in an IRA, and they are in the 10% bracket, if that. I'm sure a lot of years they don't even file taxes. So they had the idea of taking the money out and paying off a mortgage. We did a different episode about paying off your mortgage when you're retired. We have a nice debate about that. But if this person took out the $250,000, they would go from paying almost zero in taxes to the $250,000 bracket. And they might have withholding on those taxes, so maybe they get $180,000 or something. But that withholding might not even be enough. They might owe more. So my two cents was at least spread it out over two years, if not three.
John: Right.
Bridget: Unless you've got some use for it that you want to do now.
John: Yeah. But I love that idea. As you were describing that situation with your friend, I was thinking, oh, wait a minute, what if you take out $50,000 a year for three or five years. And then rather than paying 24% or 32% in taxes, or whatever that bracket is, maybe now you're only paying 12% or even 22%. It’s a matter of managing the brackets as it goes along. So know that you can. Sometimes on the flip side, we get people who inherit an IRA and maybe in the old days they were taking those minimum distributions, and it's a $25,000 IRA.
And again, that’s a great amount of money, but when you've got to figure out and take out $1,200 this year and $1,500 that year, you go, well, geez, maybe it makes sense just to take it all out. If we're going to pay in the same tax bracket, maybe it makes sense just to empty that and then simplify lives from a tax and financial standpoint. So on one end you go, geez, maybe you want to take it all out rather than doing that minimum distribution thing or waiting 10 years or whatever.
And then on the other end you go, even if it makes sense, maybe you should wait. And you know, based on the episode that we did on paying off your mortgage in retirement, we don't necessarily agree with that. But if you want to, spreading it out over a few years could make a big difference in actual tax dollars. And so just knowing that you have those options.
Bridget: If you take out $250,000 from your IRA that year, you look like somebody who just made $250,000.
John: Right.
Bridget: That might not be how you perceive yourself or what your situation actually is, so just be mindful of that. You don't have to take it out all at once, and for amounts like the ones you bring up, it’s probably better off not taking it out all at once.
John: I love that description, “It looks like you made this much money.” That's really helpful. Listen, if I'm living on Social Security or whatever my situation is, I don't think of myself as having made $250,000. But the tax man says you did. I think I just took this money out to pay off my mortgage. But from a tax standpoint, it's like you earned that money and you made that kind of dough. And so just being sensitized to that and being aware of that thing.
Bridget: Okay, we got more points. Let's move on.
John: Yeah, I was thinking of a similar line to that. There are some exceptions. We're talking in generalities about how all this stuff works. And this applies to 85% or 95% of people. There's one place that is a very common inheritance issue with IRAs, and it comes when you're a spouse. And a spouse has different rules than other people. And one of the main differences is that as a spouse, if my spouse dies, I can take her IRA, and I can have an inherited IRA, which is a specific tax thing, or I can take her IRA and I can turn it into my own and consider it my own IRA. When my mom dies, in general, I say, listen, I take her IRA. I have to have an inherited IRA. If it's not a spouse, 99% of the time that's an inherited IRA.
It kind of works like a regular IRA, but it has specific differences from a tax standpoint. But when I'm a spouse, I can take my spouse's IRA and turn it into my own. And so, it's important to be aware that you can do this. But the other thing about it is that many people in the financial world say, “Oh, you know, it's your spouse. You should take that money and turn it into your own IRA.” Which is the right answer most of the time. But there's one place I want to bring up where a spouse might not want to have that be their own IRA. In general, that makes sense, but here's the situation where it doesn’t. I had a friend who was in her early 50s. Her spouse was quite a bit older than she was. I think he was around 70 or so when he passed away.
He's 70, she's 53. He dies, so now she's got his IRAs available to her. What should she do? We're talking, and she says, “Well, my investment folks say that I should turn it into my own IRA. I think that's what I'm going to do.” And she can do that. But here's the place where if she was living off of that money, hey, I'm taking distributions; I'm married, my spouse is retired, and we're taking distributions from his IRA to live on. If I turn that into my own IRA and I'm 53 or 55 years old, guess what? As a 53-year-old, I can't access my IRA without paying penalties until I'm 59 and a half.
Bridget: Right.
John: Many people are aware of that 59 and a half rule. It's kind of sticking out there. We've got past episodes talking about that. But if I inherit the IRA, I can take distributions from an inherited IRA with no 10% penalty. From my IRA, generally speaking, I can't take the money out before 59 and a half without paying a 10% penalty. And so, it's this set of circumstances where if there's an older spouse that passes away and you're not 59 and a half, make sure you think about that. It might make sense to do it either way, but don't just automatically default to, hey, I can turn it into my own IRA. That's a big one.
Bridget: That's a really important issue. That’s an awesome exception to the rule. And it happens more than people think.
John: Let me jump in on one more thing, Bridget. There's one other thing that was on my mind as far as our topics of things. When you inherit an IRA, you've got this separate tax thing. Let's assume I'm not a spouse and turn into my own. I've got an inherited IRA. One of the strategies that we talk about quite a bit is doing conversions of IRAs to Roth IRA for tax purposes. For an inherited IRA, we can't do that directly. There are some backdoor ways we can maybe do it, but for an inherited IRA in general, we can't convert that to a Roth IRA.
But what we can do with an inherited IRA is if I were over 70 and a half, we can take IRA money from an inherited and give it to a charity using the qualified charitable distribution (QCD). I can take money out of the IRA and not pay taxes on it by giving it to charity. So the circumstance would be, listen, I inherited an IRA. I'm over 70 and a half. I've been writing checks to my church and to United Way and to wherever I give money to. Well, geez, why don't I take it out of this inherited IRA and avoid the taxes on those distributions? So you can do a, qualified charitable distribution, give money to charity from an inherited, but you can't do the Roth conversion thing.
Bridget: Yeah. And that's a nice way to make your charitable contributions if you're in a situation where you've got an inherited IRA and you're over 70 and a half. Yeah, that's the best way to do it. It's nice and efficient.
John: Yep. Well, I think that's a great place to wrap things up here in talking about inherited IRAs and some of the issues that aren't typically talked about. Again, I'm John Scherer, and I run a fee-only financial planning practice in Middleton, Wisconsin.
Bridget: I'm Bridget Sullivan Mermel. I've got a fee-only financial planning practice in Chicago, Illinois. John and I are both taking clients, but if you're interested in finding an advisor in your area. We're both members of ACP, or the Alliance of Comprehensive Planners. And you can find an advisor in your area at acplanners.org.
John: And don't forget to hit that subscribe button.
At Sullivan Mermel, Inc., we are fee-only financial planners located in Chicago, Illinois serving clients in Chicago and throughout the nation. We meet both in-person in our Chicago office and virtually through video conferencing and secure file transfer.
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